Pros and Cons of Paying Off a Car Loan Early

Benefits of Paying Off a Car Loan Early

There are several advantages to paying off your car loan early.

Save Money on Interest

Paying off your car loan early reduces the amount of time interest can accrue, lowering the total amount of interest you pay over the life of the loan. Once the loan is completely paid off, you no longer owe interest. Since most interest is charged at the beginning of an auto loan when your balance is bigger, paying the loan off sooner can lead to greater interest savings.

Lower Your Debt-to-Income Ratio (DTI)

Eliminating a monthly debt payment lowers your debt-to-income ratio (DTI), which can improve your chances of qualifying for other loans, like a mortgage. Your DTI is calculated by dividing your total monthly debt payments by your gross monthly income and multiplying by 100 to get a percentage. For example, if your total monthly debt payments are $1,400 and your income is $4,000, your DTI would be 35%. Lenders typically prefer a DTI of 35% or lower, though some may accept up to 50%.

Free Up Some Money

Once the loan is paid off, you eliminate a monthly expense, giving you more financial flexibility. You can redirect those funds towards savings, investments, other debts or discretionary spending. Having fewer financial obligations can also reduce some stress.

Take Ownership of Your Car

Paying off your car loan gives you full ownership of your vehicle, allowing you to sell, trade or modify without lender restrictions. Once you own the car outright, you have the option to reduce insurance coverage, which can lower your premiums.

Learn more: Will Paying Off a Loan Improve Credit?

Disadvantages of Paying Off a Car Loan Early

There are also some drawbacks of early car loan payoff to consider as you weigh your options.

Slight Drop in Your Credit

Closing an installment loan can result in a slight dip in your credit score, especially if the loan was one of your oldest accounts or your only installment loan. However, the impact is usually temporary as long as you continue handling your other credit accounts responsibly.

May Incur a Prepayment Penalty

Some lenders charge a fee for paying off a car loan early. A prepayment penalty can reduce or negate the interest savings of early payoff. Review your loan agreement or check with your lender to determine whether there's a penalty for early payoff.

Could Hurt Your Cash Flow

Using a lump sum to pay off your loan can deplete your savings or reduce your emergency fund. This leaves you with less cash available to cover unexpected expenses. Be sure to keep enough cash to cover emergencies.

Tip: Many experts recommend keeping three to six months' worth of basic living expenses in emergency savings.

Money Could Be Better Used for Other Debts

Paying off your car loan may not be the best way to spend extra money. If your loan has a low interest rate, you may achieve greater savings by paying off high-interest debt, such as credit card balances.

Learn more: What Debt Should I Pay Off First?

Should You Pay Off Your Car Loan Early?

The decision to pay off your car loan early depends on the terms of your existing loan, your savings balance and other financial obligations. Here's a simple overview of when it may be a good idea to pay off your car loan early and when it may not.

Paying off your car loan early may be a good idea if:

• You have a high-interest auto loan and want to save on interest costs.
• You have a stable emergency fund and extra money for the payoff.
• You want to free up money for a future purchase.
• Your loan agreement doesn't include a prepayment penalty.

On the other hand, it may not be worth paying off your car loan early if:

• You have a low-interest auto loan and investing the money could yield better returns.
• Paying off the loan would drain your emergency fund.
• You have high-interest rate debt which should take priority.
• You're planning to apply for credit soon.

How to Pay Off a Car Loan Early

If you're considering paying off your car loan early, you have a few options.

Make a Lump-Sum Payment

You could consider using savings, bonuses or windfalls to pay off your remaining car loan balance in one go. Start by requesting a payoff quote from your lender that includes the total amount due, including principal and interest. You'll need to make sure the payment is sent by the "good through" date on the quote.

Depending on the balance, you may need to pay off your loan with a certified check, money order or wire transfer. After your payment is processed, the lender will release the title, clearing any liens.

Increase Your Monthly Payment

You can pay off your car loan faster by adding extra funds to your regular payment, specifying that the extra amount should be applied to the loan's principal. You can also use tax refunds, work bonuses or other extra income to pay down your loan balance. Even small increases can reduce the total interest paid and help you pay off the loan sooner.

Make More Frequent Payments

Instead of one monthly payment, split the amount in half and pay every two weeks. You'll end up making a full extra payment each year, reducing your principal faster. You may also save on interest by paying more than once per month.

Learn more: How Can I Pay Off My Car Loan Faster?

The Bottom Line

Paying off a car loan early offers multiple advantages, including interest savings and more flexibility in your budget. However, it's important to consider potential downsides like prepayment penalties or less cash for other goals.

After paying your car loan, check your credit report to ensure the loan payoff is reported correctly. Monitor the impact to your credit score so you're prepared to get credit cards or loans in the future.